Fund administration must make digital shift | USAEMALL.com

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is chief financial officer at Schroders

Advances in a range of technologies have brought the investment industry to the brink of a major step into the future. The evolution of artificial intelligence, big data and distributed ledger technology are the game-changers. While the world of investment has modernised in recent decades with processes automated for efficiency, a switch towards digital assets could fundamentally rewire the industry.

This could bring together the current plethora of processes across the industry and enable transactions that are quicker, simpler, more traceable and less prone to error. It means portfolios could be created that are fully personalised to individual investors.

So-called “composable finance” would break down investing to digital building blocks packaged as tokens. Today fund managers and investment advisers put together a portfolio of traditional assets — mutual funds, bonds, equities, commodities etc — that they think is the best approximation of what their client needs. But there are limits to how precisely this can be tailored.

An investor can only buy a whole bond, not just the bits of it we might really want. Composable finance solves these challenges, for both issuers and investors. Programmable smart contracts and tokens — which self-execute actions when certain conditions are met on blockchain networks — would mean portfolios can stay aligned with investors’ individual goals. A client specifies they don’t want exposure to certain sectors of the economy? Programmed correctly, the code in the tokens could make it impossible for these to be added to their portfolio.

It could also automate, by design, much of the legwork currently done in markets. Traditional assets require significant teams across the fund management industry to keep finance moving — we create and destroy units in funds, we process corporate actions such as dividend payments, and execute buy and sell orders.

From a watchdogs’ point of view, the potential wins are huge. Digital marketplaces can be made compliant by design, building in requirements such as anti-money laundering rules into the tokens themselves.

But composable finance is a major departure from where we are today. Providers will need to find ways to offer digital components which offer immediate benefits in today’s market and help build familiarity. These component solutions will need to integrate existing structures and players. Just like we have cash, credit cards and digital wallets coexisting — so we will need to find a way to have tokens, ETFs and mutual funds cohabiting.

One clear example would be tokenised money-market funds. Stablecoins — digital assets pegged to the dollar or other currencies — are increasingly popular. But owners of stablecoins often forgo the returns generated by the underlying fiat currency. A tokenised MMF could facilitate stablecoin transactions in the same way, while also providing a currency yield.

This type of service is one example of a bridge between traditional finance and the new digital universe that the industry is moving towards. There is already a rising acknowledgment of stablecoins by regulators: in the UK the government has just published draft provisions for regulating crypto asset exchanges and stablecoin issuance. There is established regulation in the EU and emerging rules in the US.

And in a world where some people don’t feel confident engaging with traditional capital markets but do buy crypto, the fund management industry needs to do more to better appeal to digitally native younger generations. Composable finance will help.

If this is the future, what are the blockers? Experience in recent years suggests there are two main reasons. Firstly, while regulation is generally technology neutral there remain lots of detailed rules based on current products. Blockchains and tokens, by their very nature, go beyond the shape of the current market structure. Regulation needs to take the same leap into a truly principles-based approach.

Secondly, the existing industry processes have given rise to layers of intermediaries and specialist profit centres which are at risk in a true transformation. The enormity of this legacy and the cost to change these create pockets of resistance. Asset management has been transformed before, and can do it again. The key is to start the journey with tangible examples that move the industry forward, educate investors and encourage investments back into a regulated but more agile capital markets infrastructure.